Savvy Investors Need to Stay the Course
By David Roda
Wells Fargo Private Bank
Investors face a variety of uncertainties today that could derail their resolve to maintain fully diversified portfolios aligned with their long-term investment objectives and risk budgets. This heightened sense of concern is being fueled by many factors, including economic weakness in China, uncertainty around Federal Reserve policy, and a collapse of oil prices and other commodities. In response, equity market volatility has risen sharply in recent months with the S&P 500 experiencing its first 10 percent correction in over four years. In an environment characterized by rising volatility and record-low interest rates, what is the savvy investor to do?
Our advice is to stay the course, remain highly diversified, and look for opportunities to take advantage of major demographic, technology, and policy trends.
“Staying the course” requires that investors clearly define their long-term financial goals and design an investment portfolio that is capable of meeting those goals under varying market conditions with the least amount of risk over time. We often think of risk in terms of portfolio fluctuations associated with short-term market gyrations, but in reality the biggest risk most investors face is the risk of failing to achieve their long-term goals.
Human nature compels us to run from perceived danger and to seek safety in numbers, yet in the realm of investing the best time to buy is usually when others are selling and the best time to sell is when the herd has already moved in on the opportunity. History shows that the bulk of stock market returns have occurred over very brief periods of time.
Consequently, market timing is not a reliable strategy for long-term investors because the probability of consistently getting in and out of the market at the right moment is extremely low. Holding excess cash during periods of market volatility may feel like the safe bet, but not being invested during these quick upswings can greatly reduce long-term performance, and at today’s yields, cash does not even cover the cost of inflation.
In short, discipline trumps emotion. Don’t overestimate your ability to consistently call market turns that even the most highly trained investment professionals fail to navigate with precision.
Diversifying investment holdings across a broad number of asset classes and geographies can help to reduce portfolio volatility due to the fact that at any given time, a decline in the price of one investment is likely to be offset by a rise in another. Therefore, a bad outcome in any single investment will not have a catastrophic impact on the overall portfolio.
Nonetheless, many investors have a tendency to concentrate their portfolios in those asset classes that have performed best in the recent past. Since the lows of April, 2009, the S&P 500 has significantly outperformed most international equity indices, producing annual returns of over 16 percent including dividends through August of 2015 and prompting many investors to concentrate their holdings in U.S. stocks. These outsized returns were driven in part by corporate earnings growth and as a result of a rise in valuations from depressed recessionary levels.
Highly favorable returns in U.S. stocks cannot persist indefinitely, however, that in no way implies that the bull market in U.S. equities is over. To the contrary, Wells Fargo Investment Institute (WFII) is recommending an “overweight” position to both U.S. and international developed market stocks. The U.S. economy is healing, corporate profits are rising, home prices and employment are gaining momentum, and consumer net worth is now at an all-time high.
The imminent reversal of Federal Reserve interest rate policy may constrain investor optimism in the near-term, but the gradual nature of future rate hikes should not derail the economic recovery. The U.S. is a net importer of oil and lower energy prices translate into increased consumer spending power, which benefits the broader economy.
Overall we expect the U.S. economy to grow roughly by 2.5 percent in 2015 and at a slightly higher pace in 2016. In this environment, equity returns should pace earnings growth and volatility should increase toward historical norms. As a result, there will be more dispersion among individual winners and losers with earnings growth being the primary differentiator among competitors.
Similarly, the international developed equity markets in Europe and Japan are poised to benefit from very low-interest rates and aggressive bond buying programs initiated by their central banks. While we are not declaring an economic “liftoff” in Europe or Japan, we have seen broad-ranging signs of economic stabilization and we expect to see some growth in 2016.
The obvious fly in the ointment is China. China is the world’s second-largest economy and it has been a significant engine of global growth during the post-recession recovery. However, growth has slowed due to a combination of factors, including weakness in the manufacturing export sector driven by slow global demand and a rising currency – the cumulative impact of years of monetary and fiscal policies aimed at fighting inflation and containing credit growth, and a concerted effort by the government to enact policies aimed at reducing China’s dependence on the export of manufactured goods.
Now that growth has slipped below the government’s stated threshold of 7 percent, we have seen a slate of pro-cyclical policies aimed at reviving China’s economic trajectory. While we do not expect its economy to return to high-single-digit growth, we do anticipate stabilization at or near the current level of roughly 6 percent, which should take the edge off of investor worries about China’s economy.
Overall, 2016 is likely to be a year of uneven growth and increased market volatility. The global economy may be exhibiting growing pains, but six years of post-recession data show that the U.S. banking system has fully recapitalized, companies have lowered costs and restructured balance sheets, and consumers have reduced debt and rebuilt wealth. Trends in technology innovation as well as global demographics are creating opportunities and risks for investors.
The mere fact that individuals are living longer in a low-interest rate environment suggests that the chance of outliving one’s savings has increased, even for the wealthy. Therefore, having a detailed financial plan is essential. Diligent execution of the investment strategy around that plan will greatly increase the probability of a successful outcome in the long term.
David Roda is regional chief investment officer for Wells Fargo Private Bank.